Tag Archives: MMP

Responses to the latest in the “MMT for Austrians” series will be delayed until tommorow. In addition to addressing questions and comments concerning the MMP piece, Prof. Wray will also deal with others raised in Dan Kervick’s recent two part series. Stay tuned!

Ok: 32 comments and counting. Must be a record. Way too many to respond to. I guess we need another full blog. You either love them or you hate them. Apparently there’s no in-between. Also I note that reporter John Carney has picked up my MMT for Austrians blog and written several of his own ideologically-infused interpretations that have almost no earthly grounding.

In the past couple of weeks we turned to the question what should government do, and last week we discussed the concept of the public purpose.

Clearly, we want the economy to do a lot of things for us, and the non government sector(s)can accomplish much of that. Some of the non government provisioning is non-monetary—outside markets. For example, the unpaid work within the family.Much is provided from the “monetary production economy”—the part of the economy in which production begins with money in order to end up with more money. (Some readers will recognize the source of that—and we’ll have more to say in a few weeks.)

But while non monetary plus monetary production by the non government sector(s) can accomplish a lot, they cannot provide everything we want.

It can even be argued that as societies become richer and more developed (some even use the term “advanced” but that can be invidious) we develop “higher-order” needs and wants.

(I do not want to go into this here, but it could be argued that in moving from, say, a tribal society to a monetary capitalist society we will need much more provisioning from the center precisely because less will and can be done by kinship organizations. To put it simply, moving to a monetary economy inevitably puts more responsibility on the issuer of the money—the sovereign government.It is in a sense a two-pronged fork: monetary economies “advance”, creating more higher order wants and needs that can only be satisfied monetarily, and by the government that issues the money.)

If you look back at our discussion last week of recognized human rights it might be apparent that we need to look beyond the production within the household and the production by for-profit firms to ensure those rights. In other words, the“public purpose” may well expand.

In addition, if we take account of environmental sustainability considerations,the scope for the public purpose likely will expand. (Those familiar with the work of Karl Polanyi will recognize the relation to the argument about the“double movement”. Capitalist development creates environmental problems that require a public response.)

Arguably the most contentious debate between left and right is over the best way to achieve the public purpose. As I admitted last week, there are some who would go so far as to deny the concept altogether and perhaps even a greater number who would deny most of the listed human rights. But let us proceed with our discussion here taking it for granted that there is some recognized public purpose. The point of contention is over the best way to provide for it.

Conservatives tend to argue that the government’s scope should be very narrow, even given agreement on the public purpose. They believe that households and firms can provide for most economic needs and wants. Government is needed in narrowly confined areas—such as police and military. There is often reference to the benefits of “free markets” and to Adam Smith’s notion of the invisible hand. Tobe very brief, this is the idea that individuals pursuing their own self-interest are guided “as if” by an invisible hand to do what is actually in the interest of society as a whole. The guiding is done by the market, and more specifically by prices that act as signals. If more lawyers are needed, their salaries are bid up in the market and students react by switching to the study of law. You all get the picture. It is a very nice metaphor.

There are two problems with the story. First, it is not really Adam Smith’s view. Second,economic theory has pretty much destroyed any hope that real world markets could possibly work that way. And I am not talking about Keynesian or other critical economic theory—I’m talking about economists who desperately wanted to“prove” that the invisible hand works in the proffered manner.

Again, I’ll be brief but let’s look at these two problems before moving on to the topic of MMT for Austrians.

Adam Smith and the Invisible Hand

One of the greatest scholars of Adam Smith, Warren J. Samuels, recently published a book on the invisible hand metaphor. (Erasing the Invisible Hand: Essays on an Elusive and Misused Concept in Economics. New York: Cambridge University Press, 2011. xxviii + 329 pp. $95 (hardcover) ISBN: 978-0-521-51725-6.) It was reviewed by Gavin Kennedy (here: EH.Net (February 2012). All EH.Net reviews ar earchived at http://www.eh.net/BookReview). Since hand waves about the invisible hand and references to Adam Smith as the father of the notion are so commonplace, I want to quote extensively from Kennedy’s review.

Quote: “Smith did not”coin” the phrase. It was prevalent in classical times from Aeschylus through to St Augustine, and later, in numerous seventeenth- and eighteenth-century theological texts, sermons, plays (Shakespeare), poems, and novels (Defoe, Walpole), and in political rhetoric (George Washington). … Adam Smith used it only twice as a metaphor in his Theory of Moral Sentiments (1759)and Wealth of Nations (1776), and once in his History of Astronomy (1795,posthumous). After Smith, there was an absence of mentions of the invisible hand metaphor among economists to 1875 and near silence thereafter until it was rediscovered and re-invented into the “founding concept” of modern economics from the 1940s… Samuels discusses Adam Smith’s supposed use of the invisible hand in his political economy. … Samuels’ conclusions in Essay 10 are best summarized by his question: “what is left of the invisible hand” (p.293) and by his answer: “There is no invisible hand as that term is used in economics. Its continued use must at its base constitute an embarrassment. Almost all uses of the term add nothing to substantive knowledge”.”

Quote: “Smith used the metaphor of “an invisible hand” to”describe in a more striking and interesting manner” their particular objects: it was the absolute mutual dependence of the “unfeeling landlord” on his serfs, servants, and tenants (‘no food, no labour’), and their mutual dependence on him (‘no labour, no food’), which mutual dependence led him to share his crops with them, unintentionally benefiting humanity through the “propagation of the species” (Theory Moral Sentiments,1759, p. 185); and it was the insecurity felt by some, but not all, merchant traders, that led them to prefer to invest in “domestick industry” (mentioned four times), rather than risk the “foreign trade of consumption”(Wealth Of Nations, 1776, p. 456), also unintentionally benefiting society by adding to domestic revenue and employment. Smith’s use (History of Astronomy, 1795, p. 49) of the “invisible hand of Jupiter” simply states the pagan beliefs of Romans about their god, Jupiter, whom they believed (but never witnessed) cast his lightning bolts at humans. In all three cases, it is evident that for Smith the “invisible hand” does not exist; it is an imaginary figure of speech and an imagined pagan belief. We cannot see, but we can imagine; we may choose to believe or not to believe. The “invisible hand” “corresponds to nothing in reality,” it “contributes nothing to knowledge,” and is a “distraction and a diversion, (Samuels, p. 146).”

So what we actually see in Smith is use of the invisible hand to discuss the relation of the feudal lord to his peasants (obviously, this is pre-capitalism and hence pre-“market economy” as it is a relation based on visible force rather than the invisible hand of prices), in relation to his belief that there is a somewhat natural inclination to produce for domestic consumption, and finally to movement of heavenly bodies. None of these has anything to do with price signals and invisible hands leading to efficient allocations of scarce resources.

No wonder economists paid almost no attention to Smith’s notion of the invisible hand until after WWII!

Postwar Developments in General Equilibrium Theory

o be sure there had been an attempt from the 1870s to demonstrate the idea that markets would tend to generate a “general equilibrium”—even if it did not refer to Smith or the invisible hand.

Discussion of this topic can get quite difficult, but what conservative economists wanted to show it that “demand and supply” for all produced goods and services could be brought into equilibrium by flexible prices and wages. If every market is in equilibrium, where demand equals supply, we call that a general equilibrium.

I am simplifying but this is good enough for now. In any case, it turns out to be a very difficult thing to show and believe it or not requires higher mathematics. Indeed, it is so complex that proof of the existence of general equilibrium was not accomplished until the 1950s—some 80 years after the project began. And even then the results were extremely disappointing.

First, the conditions required to demonstrate existence of equilibrium (technically a vector of relative prices that eliminate excess demand in every market) require a very simple and unrealistic world. For our purposes it is relevant to note that the hypothesized world would never use money! (Students of economics also know it requires no time, no uncertainty, a Walrasian auctioneer, and so on. Essentially, you contract at birth for all transactions you will ever make over your entire life, with perfect certainty and no regrets.)

Second, it turned out that the equilibrium is neither unique nor stable. Indeed, it turns out that there are many equilibria, perhaps an infinite number, and we cannot say that any one is better than any other. And if we do not happen to be in equilibrium, market forces will not move us to one of the equilibria.

Pretty darned disappointing since the whole claim was that “free markets” would move us to equilibrium with prices signaling how best to allocate resources.

They won’t. At least we cannot demonstrate that they will.The “invisible hand” is completely impotent. Might as well have a dictator. Or a dictatorship of the proletariat. Or a coin toss. Or winner-take-all. Or any other method of trying to allocate resources. We cannot show that markets would do a better job.

Anyone who tells you that economics shows that the invisible hand “works” is a fool or a liar or confused. Plain and simple, rigorous economic theory shows no such thing.

(In 1926 Keynes wrote a great essay on “The End of Laissez Faire”; I won’t go through it in detail but what he argued is that no economist had ever accepted the notion that the free market “works”. He said that only political ideologues pushed that idea, an idea he thoroughly destroyed in his essay. However, in the last third of the essay he tried, and failed, to produce an alternative view. It took him ten years—until 1936—to create the alternative, what became The General Theory. It wasn’t until he formulated his theory of effective demand and addressed the “special properties of money” that he could counter the free market ideology.)

Now, why did I devote so much space to a discussion of the invisible hand? Because so many “free market marketeers” rely on the notion,and on the supposed authority of Adam Smith, to push their ideological agenda.

To be clear, the inability to demonstrate that an invisible hand “works” does not settle the issue. It does not in any way “prove” that “big government” is better than “small government”. It does not “prove” that the best way to ensure the public purpose is to rely on government rather than markets. And it does not demonstrate that we should adopt an expansive, progressive view of the public purpose. But it does make one highly skeptical of “invisible” hand waves about “free markets”.

Yet, it must be admitted that in truth, economics, alone,cannot answer those questions.

Let us now return to the topic at hand: can an Austrian adopt MMT?

MMT for Austrians

I am using Austrians as an example of those who prefer a narrow view of the public purpose and who believe that “free” markets can accomplish most of the public purpose. Hence, the role for the government should be quite limited. Obviously, Austrians are not the only conservatives who adopt these views. However, they provide a reasonably consistent and coherent alternative to both orthodox and heterodox approaches to economics.

(Some include Austrians within heterodoxy, and there are some affinities—on topics like time, expectations and uncertainty. While I recognize similarities on those dimensions, most of the rest of heterodoxy accepts elements of Keynesian, institutionalist and/or Marxist thought that are anathema to Austrians. Hence I put Austrians in their own camp. For the purposes of the discussion that follows, this is not really important.)

Austrian views on government are well-known. Further, Austrians are frequent commentators on MMT blogs, and many have asked whether Austrians can accept MMT.

I would assure Austrians that MMT is not just for advocates of big government. Indeed,I have always been surprised that some of the most vehement critics of MMT are some of the libertarians and Austrians.

Relatedly, often when there is an MMT blog, the comments are dominated by conspiracy theorists, haters of government, and goldbugs who are certain that MMT-ers ar eunited in their effort to ramp up government until it consumes the entire economy. Some Austrians agree on these critiques. This section will attempt to put those fears to rest.

First, on one level, MMT is a description of the way a sovereign currency works. Love it or hate it, our sovereign government spends by crediting bank accounts. Over the past 20 years, MMT has investigated, analyzed, and documented the sordid operational details. We can lecture for hours on the balance sheet manipulations involving the Treasury, the Fed, the primary security dealers, the special depositories, and the regular private banks every time the Treasury buys a notepad from OfficeMax. We did the work, so you our Austrian colleagues do not have to do it. And believe me, you do not want to do it. You can skip directly to the conclusion: “Yes, government spends by crediting bank accounts, taxes by debiting them, and sells bonds to provide an interest-earning substitute to low-earning reserves.”

A few libertarians and Austrians now get this, although instead of thanking us for a job well done, some of them immediately attack MMT for explaining how things work. Now, why would they do that? Because they fear that if we tell policymakers and the general public how things work, democratic processes will inevitably blow up the government’s budget as everyone demands more from government—that is for precisely the reason that Samuelson advocated that “old time religion, without which off we go to Zimbabwe land, with hyperinflation that destroys the currency.

Ok, understood.

But MMT-ers fear inflation, too. Indeed, “price stability” has always been one of the two key missions of UMKC’s Center for Full Employment and Price Stability (http://www.cfeps.org/).

(I note that my friend Edward Harrison has long pushed MMT at his own blog, http://www.creditwritedowns.com/ even as he vocally disagrees with many of us on the role of government. So there are exceptions who recognize that MMT is useful for economists of all persuasions.)

To be sure, many libertarians and Austrians believe that the only foolproof method for avoiding inflation is to go back to gold. Again, fine. But don’t criticize our labor “buffer stock” scheme for its political infeasibility! Going back to the gold standard is even less likely. (I’d place my bet on socialist sharing of undergarments as more likely than a return to gold.)

Anyway, we (also) do not want black helicopters flying around dropping bags of cash; and we (also) oppose government “pump-priming” demand stimulus—the libertarians and Austrians and even Milton Friedman are correct in their argument that this would generate inflation.

Come to think of it, MMTers have more in common with Austerians than with “military Keynesianism” that supposes that high enough spending on the defence sector will cause full employment to“trickle down”. Most MMTers believe we’d get intolerable inflation before the jobs trickle down to Harlem.

In any case it is true that there is a second level to MMT: we use our understanding of the way money works to bring rational analysis to government policy-making. Since involuntary default is, literally, impossible for a sovereign government, we quickly move beyond fears about government deficits and debt ratios and all the other nonsense that currently grips Washington.

Can we “afford” full employment? Yes. Can we “afford” Social Security? Yes. Can we “afford” to put wine in all the drinking fountains? Yes.

The problem IS NOT, CANNOT BE about affordability. It is about resources.

Unemployment is easy: by definition, someone who is unemployed is available to hire. So government can put them to work. (See the next blog series for a plan.)

Social Security is a little more difficult: can we move enough resources to the aged (plus their dependents, and people with disabilities) so that they can enjoy a comfortable, American-style, life? On all reasonable projections of demographics and US ability to produce, the answer is yes. The projectionscould turn out to be wrong. But if they do, affordability still will not be the problem—it will be a resource problem.

Finally, wine in drinking fountains? There probably is not enough fine wine, but we could probably fill all the drinking fountains with cheap French wine. If we run out, Missouri can fill the gap (for those who do not happen to live in the US Midwest, the big MO before prohibition was second only to NY in wine production.)

Again, it is a resource problem and if we convert the American and Canadian prairies to wine production we could even resolve that one.

Perhaps the most important policy pushed by most MMT-ers is the Job Guarantee/Employer of Last Resort proposal. This provides a federal-government funded job to anyone who wants to work, at a uniform, basic compensation (wages plus benefits).

Many of our libertarian/Austrian fellow travelers seem to hate this program, again for unfathomable reasons. I suspect that they have misinterpreted this to be some kind of Big Government/Big Brother program based on a weird combination of force plus welfare.

The claim is simultaneously that it “forces” everyone to work, and that it also pays everyone for not working.

Actually, it is a purely voluntary program, only for those who want to work. Those who will not work cannot participate.

Libertarians and Austrians ought to love it. It is not Big Brother. It is not even Big Government. The jobs do not have to be provided by government at all. No one has to take a job. It is consistent with, I think, the most cherished norms of freedom-loving libertarians and Austrians.

So to sum up:

1. MMT is consistent with any size of government. It can be a small libertarian government if desired. But it issues a sovereign floating currency. It supports the currency by imposing a tax payable in that currency.

2. Job Guarantee/Employer of Last Resort is also consistent with any size of government. If you want a big private sector and small government sector, keep taxes and government spending low. That frees up resources to be used by the big private sector. But you will need the JG/ELR to take up the labor resources the private sector cannot fully employ.

3. JG/ELR can be as decentralized as desired. I think there are massive incentive problems if you have federal government pay wages of for-profit firms. So I would have federal government pay the wages in the program but have the jobs actually created and managed by: not-for-profits, local government, maybe state government, maybe only as a final last resort the federal government. Argentina experimented with cooperatives and they looked to me to be highly successful.

4. The problem with a monetary economy (you can call it capitalism if you like) is that from inception imposition of taxes creates unemployment (those looking for money to pay taxes). We scale this up to our modern almost fully monetized economy (you need money just to eat, watch TV, play on cell phones, etc) and we get everyone looking for money (and not just to pay taxes). It is sheer folly to then force the private sector to solve the unemployment problem created by the government’s tax. The private sector alone will never (never has) provide full employment. ELR/JG is a logical and empirical necessity to support the private sector. It is a complement not a substitute for private sector employment.

5. How can the belief that all ought to work, and contribute to society, rather than lay about and collect welfare be called socialism? How can the offer of paid work be called slavery or fascism? It merely offers paid work for those who want to work, to contribute to society.It enhances choice and freedom.

This week we’re looking at the public purpose. Clearly, liberals and conservatives (used in the American sense of those terms) disagree on what government ought to do. Still, most people do see a substantial role for government to play. And most democratic nations have signed on to the UN Charter on Human Rights. At least one commentator rejected most of the rights I listed on Monday. And one presumes that many of the supporters of the most conservative Republican candidates campaigning in the US would join in bashing the UN Charter. Heck, one of the candidates seems to suggest that just knowing a foreign language makes one unfit to run for US President! Many Americans think that anything that comes from the UN is suspect.

The households and business firms in a modern capitalist economy make many of the important economic decisions that contribute to determination of the level of employment and output, the composition of that output, the distribution of income, and the prices at which output is sold.

You might want to see my NEP front page piece: Mine’s BiggerThan Yours, which deals with various misunderstandings on size of government.It isn’t size that matters (beyond some minimum size—probably 15-20% of GDP),rather it’s what you do with it that counts. It is all about what governmentought to do, in other words. Ok so here are comments and my responses.

Neil: Is it worth mentioning that economic policy is aboutbeing largely right rather than precisely wrong?

A: I like it. But of course even “right” depends on “ought”.

Philip: Yes, the exchange rate is a bit of a mysteryalright. Any advice on a good book that tries to deal with these issues from aPK perspective. Preferably one that looks at the empirical evidence to somedegree. I seem to remember that John Harvey did something on this…

A: Truthfully, no one knows. No one has much of a clue,really. I like Harvey’s two JPKE papers and they might be as good as anythingout there. Add in Keynes’s interest rate parity theorem and Sraffa’s commoditypricing and I don’t think economists have much else to say. Since daily tradein financial assets exceeds annual trade in goods and services, it is clearthat whatever theory you have it must treat exchange rates in the context of atheory of asset pricing.

Dario: I am confused. Are you moving toward an Austrianapproach? May I ask you why? What’s your purpose?

A: Yes you are. Confused. My purpose is to talk about what government ought to do. What is yours? To make unfounded accusations?

Golfer: Why Crony capitalism? Because government is so bigthat the profits to be had by controlling it are irresistible. in former times,when government in the US was les than 10% of GDP, there were more profitsto be made in private enterprise.

A: Oh really. And who is the richest man in the world? Hint:Mexican. Government much smaller relative to GDP than the US government; andthe US government is (next to Japan’s) the smallest of the big economies. Lookslike more ideology than content to me. And if you really believe the USgovernment in the time of the robber barons was less crony than today’s, youlive in la-la land.

Neil: No matter how small the government gets the profits tobe had by controlling it are always irresistible. It’s the flipping currencyissuer!

A: Yep. Give me a printing press and I can move the world.

Hewer: it may be worth adding that the impetus to controlgovernment is not entirely down to the notion that profits from being acurrency issuer are irresistible. Of course that is true, but it is notsomething that those who seek to control the political process necessarilyunderstand, nor necessarily their first concern if they do. The mainbenefit to controlling government does not come from the “profits”that can be made, but rather from the control over real resources thatpolitical dominance provides.

In the nextseries of blogs we will turn to whatgovernment ought to do. This serieswill specifically treat only sovereign government—one that issues its owncurrency. From the earlier blogs, that will make it clear that we areaddressing only a government that does not face an affordability constraint.

In theseupcoming blogs we will examine alternative views about the proper role forgovernment—given that it can “afford” anything for sale in its own currency. Wefirst look at four reasons why government spending ought to be constrained. Wethen compare and contrast a typical “conservative” versus “liberal” view aboutthe scope of government. (These terms are used in the American sense—that are somewhatidiosyncratic. In America, conservative is closer to what is called “liberal”or “neoliberal” abroad. Liberal in America is closer to “social democratic” orto “labor party” abroad.)

We willwork toward developing an example of a government program that is consistentwith the MMT view of sovereign money—one that uses the principles we haveestablished in previous chapters to resolve the problem of unemployment in amanner that is consistent with both the liberal and the conservative views.That is the employer of last resort or job guarantee approach. I will concludethis series with my own view on whether MMT must include the ELR/JG proposal.

Warning:when we address views on whatgovernment ought to do, we have moved beyond description. My views of what government ought to do need not beaccepted by others, even those who fully understand MMT. I will be makingpolicy recommendations that are consistent with MMT. You do not have to likemine; you can come up with your own. I will devote a blog to an Austrianapproach to policy-making, and its goals will be different from my own.

Just Because Government Can Afford to Spend, Does Not MeanGovernment Ought to Spend. Understanding how government spends leads to the conclusion that affordability is not really theissue—government can always affordthe “keystrokes” necessary to make expenditures as desired. But that does notmean it should. We can list severallegitimate reasons for constraining government spending:

too much spending can causeinflation

too much spending couldpressure the exchange rate

too much spending by government might leave too few resources forprivate interests

government should not do everything—impactson incentives could be perverse

budgeting provides a lever to manage and evaluate government projects

Forexample, suppose government decides to newly hire 1000 rocket scientists for anexpedition to Pluto. Our first consideration is whether there are 1000 rocket scientists available forhire with the necessary skills. Even if government can afford its desired spending plan that does not mean it canaccomplish its mission if the resources are not available. In other words, thegovernment always faces a “real resource” constraint: do the resources exist,and are they for sale or hire? Related to this consideration: are the existinginfrastructure, technology, and knowledge up to the task of achieving programgoals. That, of course, is an important question. Let us presume that theseconditions are met.

The secondconsideration, then, concerns competition with alternative uses of theresources, what is called the “opportunity cost”. If those 1000 rocketscientists would otherwise be unemployed, then the opportunity cost of hiringthem for the Pluto mission is low or zero. (We might find, for example, that ifthey were not employed they would take care of their children at home so thenon-zero opportunity cost of employing them is the value of the foregonechildcare services. You get the picture—it is not likely that opportunity costsare zero, but for unemployed laborthey are probably low relative to benefits of employment in appropriate jobs.)

Moreimportantly, it is likely that many or most of them are already working, eitherin the private sector or on other government projects. Since sovereigngovernment does not face an affordability constraint, it can win a bidding waragainst the private sector if it chooses to do so. In that case, it will pushup the wages of rocket scientists so high that the private sector gives up andhires workers with other credentials. The impacts on the private sector couldbe complex—likely leading to higher wages, higher product costs, and even lessoutput in those sectors that use rocket scientists and other skilled workerswho can substitute to some degree for rocket scientists (perhaps for somepurposes, other types of engineers are almost as good, so firms bid up theirwages). At the very least, the Pluto mission could lead to“bottlenecks”—relative shortages of key resources—and some (perhaps limited)price hikes. In that case, public policy must consider the much greateropportunity cost of hiring rocket scientists away from other employment.

Inaddition, other wages and prices might be increased through spill-over effectsif a new government program is so big that it sets off a general bidding warfor labor and other resources. For example, during a major war like WWII,government not only conscripts workers into the military but it also redirectsresources to production for the war effort. Without rationing and wage andprice controls, it is relatively easy for this to lead to a general price andwage inflation. Note that it does not take a major war for this to happen. Ifgovernment spending pushes the economy to, and beyond, full employment it islikely that inflation will result even in the absence of a major war. At thesame time, high domestic employment and income can—under somecircumstances—lead to a trade deficit (as domestic demand for imports risesrelative to foreign demand for exports—discussed in the previous section). Thismight then pressure exchange rates (although the correlation between tradedeficits and exchange rate depreciation is far from certain).

Hence,while government can afford to spend more, it must weigh the consequences interms of withdrawing resources from other (perhaps more desirable) uses, aswell as possible impacts on prices and exchange rates.

There aremany other reasons to constrain government spending. For example, conservativesoften argue that spending on “welfare” affects incentives. A strong socialsafety net might send the signal that individuals do not really need to workbecause they can always live well enough on government hand-outs. Or,government bail-outs of business might encourage management to take excessiverisks on the belief that no matter what happens, government will cover thefirm’s losses.

Further, acorrupt government might spend on programs that help friends, but refuse to doanything to assist more deserving groups—what is often called “cronycapitalism”. So, there could be complexand even unintended consequences of government programs.

All of thatmust be considered when undertaking government spending programs—and negativeconsequences raise legitimate concerns about the size of government spending,not due to the (im)possibility of insolvency but rather to undesired (andunknown) effects of government programs.

Finally,governments should, and do, use budgets, which are a form of self-imposedconstraint. Typically, the elected representatives will allocate a sum to bespent on a particular project. Program managers are then held accountable forfinishing the project within the budgeted amount. Over-running the budget canbe used as an indication of mismanagement. The budgeting process also helps toreduce the incentive for “mission creep”, expanding the project to enhance themanager’s power and prestige. In other words, budgeting by sovereign governmentprovides a useful mechanism for project control and evaluation.

We concludethis section by observing that absence of an “affordability” constraint doesnot imply that government ought tospend without constraint. As we discuss in the next blog, its spending ought tobe aimed toward achieving the “public purpose”.

Sorry for being late. There were really only two issuesraised (ignoring the comment about MMR vs MMT—which I’m not going to addresshere).

The first concerned the orthodox belief that trade dependson comparative advantage: Italy specializes in wine because of its climate andsoil. In the case of agriculture in the old days, there isn’t too much doubtabout that—it was hard to grow grapes at the North Pole, so Santa tradeddelivery services for products made in southern climes. But once we move beyondagriculture, and after we’ve invented greenhouses and the like, there is muchless truth in this. In manufacturing, a factory can be set up anywhere in theworld, often in a few weeks, and it takes a couple more weeks to train theworkers. And out in the real world what we find is that much of the trade infinished goods is actually between “equals”: Italy sends Fiats to Germany andGermany sends VWs to Italy. Tastes or preferences, styles, desire to be different,brand loyalty, and all that matters much more.

The second is more important and concerns the belief thateconomic growth is balance-of-payments constrained, as described by TonyThirwall’s “Law”. As Neil “Ramanan” Wilson Jargued: “There have been some suggestions that Thirlwall’s law stops thegovernment expanding domestic policy and will cause ‘twin deficits’ problems(increased government and external deficits). But why would that apply togovernment and not private expansion? Thirlwall’s law appears to have a fairamount of empirical data behind it, but is that curve fitting? In other wordsdoes the Law appear true because nobody dare do the domestic expansion in thecorrect fashion necessary to test the underlying assumptions on which it is based.”

To simplify and summarize: A country like the US that has ahigh propensity to import will tend to run a trade deficit if we grow fasterthan our neighbors who have low propensities to import. We will then run out offoreign reserves quickly so will be constrained to the extent that ourneighbors won’t take our currency in exchange. Thus, our growth will beconstrained—it needs to be slower than that of our neighbors.

To be sure, Thirlwall would throw in lots of caveats thatare usually ignored by those who wave his “Law” about. Not all growth has thesame implications for the trade balance. Income distribution matters forimports—so it depends on who benefits from the growth. We could target ourgrowth to areas that make us more competitive internationally—increasingexports. If we do grow faster than our neighbors, their demand for our currency(to invest in the US, for example, to share in the bounteous growth) might growas fast as our current account surplus. If we float the currency, theconstraint is softened since a trade deficit might cause the exchange rate tofall and thereby increase exports and reduce imports. And we can change policyto encourage exports and restrict imports, or to encourage “capital” inflows(demand for our currency to buy assets). So for all these reasons, there is nosimple “Law”.

Neil also raises an important point usually overlooked bythose who advocate the “Law”: the evidence in favor of a constraint probablyhas more to do with policy overreaction than to any real constraint.Governments react to a current account deficit by tightening the fiscal andmonetary policy screws, trying to raise unemployment and slow growth. That is apolicy choice. Except for those nations that choose to peg their currencies (oradopt foreign currencies—as Greece did), it is almost always going to be a badpolicy. Indeed, pegging the exchange rate is a bad policy because it usuallyforces government to give up policy space. Unemployment is the normal price ofpegging—and it is pegging and the reaction to a current account deficit that thenmakes Thirlwall’s Law “bite”.

Let us say that a country does not impose the “Law” onitself, refusing to adopt austerity when a trade deficit appears. What happens?At a constant (but not pegged—this is a little mental experiment) exchangerate, for its current account to increase, there must be a demand for itscurrency so that its capital account surplus rises by the same amount. In otherwords, there are two sides to the coin, and as foreigners demand the currency,a capital account surplus is created, and as the domestic population demandsthe imports, a current account deficit is created. We cannot split the coin inhalf to blame one side or the other.

Let us say that the rest of the world (ROW) will not allowthat to happen—the ROW will accept the currency only if it depreciates. OK,then, the currency falls in value to find holders of the currency given acurrent account deficit. And as the currency falls, exports might rise a bit,and imports fall a bit. But let us say that this will not restore trade“balance” (recall from my earlier blog however that “balance” is a misleadingword—the balances always balance!). As the currency depreciates, the terms oftrade turn against the country. In other words, it gives up more currency toget the same basket of imports.

(Yet in real terms as a current account deficit is created,the country gives fewer exports to get imports! How ironic: the real terms oftrade move in the favor of a trade deficit nation. Exports are the cost,imports are the benefit.)

If you are an OZ that imports oil and finished manufactures,a depreciating A$ raises the A$ cost of much of what you buy. And as BillMitchell argues, the swings of the A$ are historically large and do lead to verylarge fluctuations of the domestic purchasing power. But so long as Australiakept its commitment to full employment, it tolerated these swings withoutimposing austerity. Policymakers preferred to use their domestic policy spaceto maintain growth with (nearly) full employment. So Oz consumers would remainemployed and would substitute out of expensive imports as best they could. Andthey’d probably have to reduce overall consumption when the Oz Dollar fell. Thosewho follow MMT and Functional Finance believe that is the best policy.

Should a nation like Oz adopt other policy in response to atrade deficit? Bill often uses the example of auto manufacture. Oz might havetried to keep out Japanese autos in order to promote Oz auto production. Billhas argued this makes little sense, and would cost Australian consumersdearly—both in terms of loss of choice but also in terms of a policy ofdevoting substantial real resources to produce autos at what might be a scalefar too small to achieve economies of scale. I have no dog in this hunt and noparticular opinion on the issue of Oz auto production. But Bill’s argumentmakes sense to me as a general statement. It is also related to the comparativeadvantage argument briefly discussed above. If you can import high quality andlow cost products from abroad, it may not make sense to use government policyto block the imports and to subsidies domestic production. Remember: importsare a benefit, exports a cost, in real terms. Of course that is only true ifyou have a commitment to full employment. So if auto jobs are lost governmentmust ensure alternative employment.

The immediate response always is: “but auto jobs are good;nonmanufacturing jobs are bad”. Only one who has never worked in a factorycould literally believe this. (Full disclosure: I worked in a soup factory andwhile I liked the pay, I hated the work.) What most mean is that factory jobspay well, many service sector jobs don’t.

The solution—of course!—is to make the service sector paymore. I am always amazed at the lengths to which people will go to offer“crazily improbable” (in Keynes’s words) solutions rather than looking to theobvious.

To be clear, I have nothing against using domestic policy ina strategic manner—to target areas for expansion. All economies area alwaysplanned. The questions are: by whom and for whom. But responding to a tradedeficit by imposing austerity simply imposes a “Thirlwall’s Law” growthconstraint unnecessarily.

There are many other issues related to imports, exports, andexchange rates—we’ll return to some of them in the remainder of the Primer.

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Let’sfinish up the discussion of Lerner’s functional finance approach addressing twoissues: functional finance and developing nations and also the functionalfinance approach to trade deficits.

Functional Finance and Developing Nations. Most of the developing nations havea sovereign currency—which means they can “afford” to buy whatever is for salein the domestic currency, including unemployed labor. As Lerner would put it,unemployment is evidence that there is an unmet demand for domestic currencythat can be filled by additional government spending. At the same time, manydeveloping nations have fixed or managed exchange rates that reduce domesticpolicy space to some degree. They can increase policy space either throughpolicies that generate foreign currency reserves (including development thatincreases exports), or they can protect foreign currency reserves throughcapital controls.

Inaddition, they can favour policy that leads to employment and developmentwithout increasing imports (import substitution policies, for example). Theycan create jobs programs that are labor intensive (so that foreign made capitalequipment is not needed) or programs that provide the output that the newlyemployed workers need (so that they do not spend their new incomes on imports).

Governmentcan favour domestic producers over foreign producers. It can limit itspurchases of foreign goods and services to export earnings. It can try to avoidborrowing in foreign currency in order to limit its need to devote foreigncurrency earnings to interest payments.

Asdiscussed, ability to impose and collect taxes can be impaired in a developingnation. This will limit government’s ability to directly command domesticoutput. And even if it finds plenty of unemployed labor willing to work for itscurrency, those workers might find it difficult to purchase output with thatcurrency at stable prices. More diligent tax collection will help to increasedemand for the currency (since taxes are paid in the domestic currency). Inaddition, government needs to focus job creation in those areas that will leadto increased production of the kinds of goods and services the new workers willwant to purchase. That can relieve inflationary pressures resulting from risingemployment.

For thelong run, avoiding foreign currency indebtedness and moving toward floatingexchange rates would be conducive to expansion of domestic policy space. Fullutilization of domestic resources (most importantly, labor) will allowdeveloping nations to maximize output while reducing inflation caused byinsufficient supply. Full employment of labor also provides many otherwell-known benefits that will not be detailed here.

A sovereigncurrency provides more policy space to government—it spends by crediting bankaccounts and thus is not subject to the budget constraint that applies to acurrency user. A floating exchange rate (or a managed rate with capitalcontrols) expands the policy space further—because the government does not needto accumulate sufficient reserves to maintain a peg. Well-planned use of thispolicy space will allow the government to move toward full employment withoutsetting off currency depreciation or domestic price inflation. To that end, theemployer of last resort or job guarantee model is particularly useful, a topicpursued in more detail elsewhere in the Primer.

Exports are a cost, Imports are a benefit. In real terms, exports are a costand imports are a benefit from the perspective of a nation as a whole. Theexplanation is simple. When resources including labor are used to produceoutput that is shipped to foreigners, the domestic population does not get toconsume that output, or use it for further production (in the case ofinvestment goods). The nation bears the cost of producing the output, but doesnot get the benefit. On the other hand, the importing nation gets the outputbut did not have to produce it. For this reason, in real terms net exports meannet costs; and net imports mean net benefits.

Now thereare several caveats. First, from the perspective of the producer of output, itdoes not matter who buys the produced goods or services—the firm is equallyhappy selling domestically or to foreign buyers. What the firm wants is to sellfor domestic currency in order to cover costs and reap profits. If the outputis sold domestically, the bank accounts of purchasers are debited, and theaccounts of the producing firm are credited. Everyone is happy. If the outputis sold to foreigners, the receipts will need to go through a currency exchangeso that the producer can receive domestic currency while the ultimatepurchasers are using their own currency. We will not concern ourselves with thedetails, but usually a domestic bank or the central bank will end up holdingreserves of the foreign currency (this will normally be a credit to a reserveaccount at the foreign central bank). The fact remains, however, that in termsof real resources, the “fruit of the labor” is enjoyed by foreigners when theoutput is exported, even though in financial terms the producing firm receivesa net credit to a bank account and the nation receives a net financial asset interms of foreign currency.

Second, netexports add to aggregate demand and increase measured GDP and national income.Jobs are created to produce goods and services for export. Hence, a nation thatwould otherwise operate below full employment can put resources to work in theexport sector. Wages and profits are generated, families receive incomes theywould not have received so that they are able to purchase consumption goods,and firms stay in business that otherwise might have gone bankrupt. This isprobably the main reason why governments encourage growth of exports. In themidst of the economic downturn, President Obama announced that his goal for theUS economy was to double its exports. This is a common strategy for nationsthat want to grow. However, note that for every export there must be an import;for every trade surplus there must be a trade deficit. Obviously it is notpossible for all countries to simultaneously grow in this manner—it isfundamentally a “beggar thy neighbour” strategy.

To theextent that resources are mobilized to produce for foreigners, the domesticpopulation does not receive any net real benefit. True, labor and otherresources that would have been left idle are now employed; workers who wouldnot have received a wage now get income; owners of firms who would not havesold output now receive profits. Yet, if the produced output is sent abroad,there is no extra output for domestic residents to purchase. What happens isthat existing output gets redistributed to these additional claimants—who nowhave wage and profit income. Thus, if we have only put unemployed resources towork in order to produce exports, there is no net benefit—the domesticpopulation is working “harder” but not consuming more in the aggregate becausethe “pie” available for the domestic population has not increased. Theredistribution process itself will probably require inflation as those who nowhave jobs compete for a piece of the pie, bidding up prices. To be sure, thiscould be a desirable social outcome—output gets redistributed from the “haves”to the “have-nots”, and putting unemployed people to work has numerous benefitsfor families and society as a whole (in terms of crime, family break-ups, andsocial cohesion).

But notethat this relied on the presumption that the nation had excess capacity tobegin with. If it had been operating at full capacity of labor, plant, andequipment, then it could only increase exports by reducing domesticconsumption, investment, or government use of resources. Labor and otherresources would be shifted from producing for domestic use toward satisfyingforeign demand for output. Clearly it would usually be preferable to achievefull employment by producing for domestic use rather than for export. Theadditional employment would provide both income as well as more output. Thedomestic “pie” would be larger, so that rather than redistributing from “haves”to “have-nots”, the newly employed would get pieces of the larger pie.

Anotherobvious caveat is that producing output for foreigners can be in a nation’seconomic and political interests. A nation might produce goods and servicesthat are sent abroad for humanitarian reasons—to aid in disaster relief, forexample. It might produce military supplies to aid allies. Foreign directinvestment could aid a developing country that might become a strategicpartner. And there is certainly no reason for a nation to balance its currentaccount on an annual basis—something that would be nearly impossible in ahighly globalized economy with international links in production processes.Hence we would not want to ignore various strategic reasons for exportingoutput and running trade surpluses.

We concludethat we should also take a “functional” approach to international trade: itmakes no more sense for a sovereign government that issues its own floatingcurrency to pursue a trade surplus than it does for that government to seek abudget surplus. Maximization of a current account surplus imposes net realcosts (given the caveats discussed above). Instead, it is best to pursue fullemployment at home, and let the current account and budget balances adjust.That is far better than the usual strategy—which is to pursue a trade surplusin order to get to full employment.

We now turnto a policy that will generate full employment at home. Next week: more on theemployer of last resort proposal.

There were a fewcomments this week, focused especially on Chinese holdings. It shouldbe clear from my post that I am not concerned about the holdings norabout a possible run. China will gradually reduce its export surplus,but it is probable that other countries will continue to want toaccumulate more dollars and so will try to replace Chinese exports tothe US with their own. The Dollar will remain strong, there will beno run. So here are the questions grouped into main themes.

Q1 (Neil): Additionally is there a casefor having a positive domestic monetary policy and a zero monetarypolicy for foreign holdings?

A: I presume you mean interest rates?Warren Mosler has advocated permanent ZIRP (zero overnight interestrates) which is essentially Keynes’s euthanasia of the rentierclass. With Bill Mitchell he advocated elimination of treasuriesaltogether—which I also endorsed several times during the US debtlimits debate. So I guess my answer would be: zero for both!

Q2: (Neil) I’ve heard a couple of notesrecently that Abba Lerner argued for the burden “The only reallyserious burden associated with government debt is that part of thedebt owed to foreigners (as Abba Lerner argued.

A: I did write about that particulararticle in which Lerner tore apart the “debt burden” argument(you should read it) in my Understanding Modern Money book back in1998. Yes there can be a “real” burden if foreigners start buyingUS output—increasing our exports. Exports are a cost, imports abenefit. But that is if we are at continuous fullemployment—something we never have, of course.

Q3 (two commentators): If by ‘dumping’US Treasuries people mean selling them, would that be a problem? Thensomeone else would be buying … American or Foreign. So what ?

A: Agreed. As I said, this is likely tobe a very slow transformation as China and others realize exports area cost and begin to produce for domestic consumption; in which casethey won’t want dollars. And yes, I agree China has got more dollarreserves than it is likely to need to protect its exchange rate. ButI suppose dollars are like nukes—better safe than sorry, so youaccumulate more than you would ever need. But eventually they willdecide they’ve got enough.

Q4: (steve) A Chinese company makes asale through a distributor in the US. They receive dollars inpayment. They have to pay their workers (and themselves) inYuan. They exchange the dollars for Yuan at the central bank. Is this done at an exchange rate completely under the controlof the PBC? Are the Yuan simply created by the PBC? Sothe dollars are now owned directly by the government? And, theyexchange these reserves for Treasury securities. Must we offerthis exchange? Or, could we force them simply to hold thereserves (until if/when they decide to buy something).

A: China manages its exchange rate, soyes it determines the Yuan it will supply against dollars that itcredits to the bank accounts. The government only allows smallholdings of dollars by anyone else in China, so yes most of thedollars go to the government—official balances.